As if interest rates weren't low enough . . .

Uncle Sam is getting yet another break on his borrowing costs.

Suddenly, cash is again fighting to get into the haven of shorter-term Treasury securities, driving yields down to levels last seen after the first stage of the financial-system meltdown a year ago.

It may look like another fear-driven panic, but this time is different: In large part the latest decline in shorter-term yields just stems from moves by banks and other financial firms to bolster their balance sheets with highly liquid assets as 2009 ends, says Tom di Galoma, head of U.S. rates trading at Guggenheim Capital Markets in New York.

"They’re dressing up the books for year-end," he said. The more liquid you can look to your regulators, the better.

Late last year the hunger for Treasuries reflected a deep-seated dread that the financial system would continue to implode. That kind of sentiment is mostly absent this time around.

The annualized yield on three-month T-bills fell to a barely positive 0.01% on Thursday, down from 0.07% at the beginning of the week and the lowest level since last December.

The two-year T-note yield slid to 0.70%, compared with 0.81% a week earlier and also the lowest since December.

Traders said some T-bills were trading at slightly negative yields -- meaning buyers were in effect paying to keep their money in the securities, as opposed to earning a return on them.

Another factor pushing T-bill yields down: Growing demand is facing a smaller supply of new debt, as the Treasury winds down some of the deficit-financing programs that had pumped up T-bill issuance. The Treasury was selling as much as $33 billion a week in three-month bills in August. This week’s auction was for $30 billion.

Meanwhile, the Treasury continues to boost sales of longer-term securities.

As for the drop in the two-year T-note yield, that shows that buyers at these levels believe there’s no risk in locking in a yield of well under 1% on those securities. In turn, that implies growing faith that the Federal Reserve won’t be raising its benchmark short-term rate from near zero anytime soon -- maybe not even in the second half of 2010, which had seemed like a reasonable window for a Fed hike.

The view that the central bank could stay on hold for longer has been buttressed by recent comments from Fed officials including Janet Yellen, James Bullard and Chairman Ben S. Bernanke.

"Fed-speak lately has been pretty dovish" on rates, notes Jim Galluzzo, a Treasury trader at RBS Securities in Stamford, Conn.

Just what the short-term end of the Treasury market loves to hear.

-- Tom Petruno

Ron Paul wins a key battle in war to open Fed's books

Rep. Ron Paul, the Texas Republican who is perhaps the Federal Reserve’s most implacable enemy, scored a big win Thursday on Capitol Hill: The House Financial Services Committee approved adding to a financial-system reform bill Paul’s provision to begin federal reviews of the central bank’s operations, including its interest-rate decisions.

The vote on the audit provision amendment was 43-26.

Paul has for years asserted that the Fed, which by design is independent of  the federal government, was corrupt and that its monetary policy would drive America to ruin by debasing the dollar.

He has sought to abolish the Fed entirely, but because that almost certainly would never fly in Congress, Paul has worked for Plan B: He wants the Government Accountability Office to have full power to audit the central bank’s operations -- a measure the Fed bitterly opposes.

"If we get the audit and get the books open, make them answer the questions, I am convinced that the American people will be so outraged that then we will have reform of the monetary system," Paul has said.

Fed Chairman Ben S. Bernanke told Congress in June that Paul’s audit provision "would effectively be a takeover of policy by the Congress . . . [and] would be highly destructive to the stability of the financial system, the dollar and our national economic situation."

Paul contends that the Fed is overreacting. Here's how he describes what the provision would do:

--- Removes blanket restrictions on GAO audits of the Fed;

--- Allows the audit of every item on the Fed’s balance sheet, all credit facilities, all securities purchase programs, etc.;

--- Retains limited audit exemption on unreleased transcripts and minutes;

--- Sets a 180-day time lag before details of Fed’s market actions may be released;

--- Provides that nothing in the amendment should be construed as interference in or dictation of monetary policy by Congress or the GAO.

The audit-the-Fed measure is part of the financial-system-overhaul bill that the Obama administration has sought. It remains to be seen whether Paul’s Fed provision can make it through the full House and the Senate.

A note to clear up any confusion: The Obama administration wants the financial-overhaul bill, but it isn't clear that it would support the addition of Paul's audit-the-Fed provision.

-- Tom Petruno

Image: Ron Paul's latest book, "End the Fed"

California cuts bond sale over prison legal battle

California today pared back its last big tax-free bond sale of 2009, citing legal questions about funding for a prison project.

Treasurer Bill Lockyer sold $743 million in lease revenue bonds for the state Public Works Board instead of the $1.34 billion that had been planned.

The deal was slashed in size because funding was dropped for a new death-row-inmate complex at San Quentin prison. The fate of that complex is in limbo because of an ongoing legal battle between the Legislature and Gov. Arnold Schwarzenegger over certain budget items that he has vetoed.

"Legal questions arose Wednesday about whether the San Quentin facility could be funded with the bonds," said Tom Dresslar, Lockyer’s spokesman. "The state did not have enough time to address those issues and decided to drop the project from the sale."

The smaller deal size allowed the state to slightly trim the interest rates on some of the bonds. For example, the Series I bonds maturing in 10 years will pay a tax-free annualized yield of 5.10%, a sliver less than the 5.12% the state had preliminarily set.

It helped the state that yield-hungry individual investors put in orders for $447 million of the bonds. That was 61% of the final total sold. A hefty number of individual-investor orders gives the state more leeway in negotiating the final interest rates on its bonds with institutional investors.

The state now has borrowed more than $21 billion since late September via short- and long-term debt for budget-related reasons and to finance voter-approved infrastructure projects. That supply glut has helped to push up tax-free muni bond yields across the board as investors have demanded higher returns to absorb all of the debt.

Fundamentally, tax-free munis remain appealing compared with taxable bonds, as I noted in this earlier post. The jump in yields over the last six weeks should reinforce that appeal.

The state’s borrowing binge is nearly over for the year, which could put downward pressure on California muni yields in the near term.  Lockyer has just one more sale of tax-free bonds planned for 2009: a $200-million issue for the University of California on Dec. 3.

-- Tom Petruno

Photo credit: Ben Margot / Associated Press

Despite fiscal woes, muni bonds' appeal stays strong

The good news in the sell-off that has clipped California tax-free municipal bond prices over the last six weeks is that the market now should be harder to shock.

So for muni investors, the report Wednesday that Sacramento already may be facing a $21-billion budget gap over the current and next fiscal years was more a firecracker than a bomb.

After rallying sharply in August and September, the California muni market has given back some of those gains since early October. Amid a flood of new bond sales by the state investors have demanded higher yields, which in turn has pushed prices of existing bonds down.

California is back in the market this week with a $1.34-billion revenue bond offering from the Public Works Board to finance infrastructure projects. Yields on those bonds will be set today.

All in all, though, the damage to the market from the supply glut has been relatively modest, at least for muni mutual fund investors who have the benefit of wide diversification. Case in point: The per-share net asset value of the Franklin California Tax-Free Income fund, which holds $14.2 billion of state and local debt, was $6.90 on Wednesday, a drop of 4% from the 52-week high of $7.19 on Oct. 5.

That’s unfortunate for anyone who bought near the high, but year-to-date the fund’s total return (share price gain plus interest earned) still is a hefty 15.6%. And that’s even better than it looks, given that the interest earned is exempt from state and federal income tax.

The muni market nationwide has been suffering a bout of indigestion since September, driving yields higher. But nationally and in California the market has been stabilizing over the last week or so.

Despite the dire fiscal outlooks for many state and local governments, there are three main reasons to believe that the muni market is unlikely to fall off a cliff from here and wipe out all of its recovery from the worst of the credit crunch:

--- Big investors just don’t buy the idea that actual defaults by muni issuers in 2010 will match the doomsday predictions that are out there.

"There is going to be a lot of ‘headline’ risk in the market over the next 12 to 18 months," said Chris Sperry, co-manager of the Franklin California fund. But local governments of any size know, he said, that the decision to default would make it impossible to get the basic credit they need to function. The market clearly believes that the vast majority of politicians will get out the cleaver and hack expenses further, not bond payments.

--- Muni yields still are historically high versus yields on taxable bonds. A 10-year California state general obligation bond now yields about 4.55% tax-free, compared with 3.36% for a 10-year U.S. Treasury note that is federally taxable. Muni bond yields normally are below Treasury yields.

"In order for muni yields to get a whole lot [higher] you’re going to have to see the Treasury market sell off," said John Carbone, manager of the Vanguard California Long-Term Tax-Exempt bond fund. That could happen, of course, but it probably would require the backdrop of a robust economic recovery or an inflation surge -- neither of which seems likely in the near term.

--- Many muni investors figure that tax rates at the federal, state and local levels can only go up as governments struggle to close deficits. That would boost munis’ appeal for yield-hungry investors. "Munis are going to become more attractive from a pure income standpoint," Sperry said.

Yes, he’s talking his book. But raise your hand if you think taxes are more likely to go down than up.

-- Tom Petruno

Bernanke on bubbles: Nothing 'obvious' at the moment

Federal Reserve Chairman Ben S. Bernanke reiterated Monday that the central bank now knows enough to be worried about asset bubbles.

He just doesn't see any in the U.S. at the moment despite some investors' concerns about stock market valuations and the still-ravenous global appetite for Treasury securities.

In a Q&A session after a speech in New York, Bernanke at first channeled his predecessor, Alan Greenspan, on the subject of bubbles: Bernanke said it was "inherently, extraordinarily difficult to know whether an asset’s price is in line with its fundamental value or not."

And he added: "It’s not obvious to me in any case that there’s any large misalignments currently in the U.S. financial system."

The Greenspan Doctrine was that it was too difficult for the Fed to know if a particular market was in a bubble (say, like housing in the mid-2000s) and that it was better for the central bank to leave markets to their own devices. We all know how that turned out.

Bernanke has made clear that the Greenspan Doctrine doesn’t rule the Bernanke Fed. Given the disaster wrought by the housing bubble, the Fed chief on Monday said that the central bank recognized the need to address the question of bubbles "in a serious way."

He said policymakers were "looking at various models of valuation for stocks, bonds and other kinds of assets" to judge their levels relative to the fundamentals.

As to whether the Fed would use higher interest rates specifically to prick a presumed bubble, Bernanke said that decision would have to be made in the context of the Fed’s two principal policy mandates -- promoting full employment and price stability.

If addressing "major misalignments of the financial markets" would further those policy goals, "We’d have to think about it very seriously," he said.

-- Tom Petruno

Photo: Fed Chairman Ben S. Bernanke speaking Monday at the Economic Club of New York. Credit: Mark Lennihan / Associated Press

Yes, Geithner's just kidding about a 'strong dollar'

Despite Treasury Secretary Timothy Geithner’s latest emphatic statement about the need to "maintain a strong dollar," financial markets know he’s not serious.

The Obama administration, like the Bush administration before it, pays lip service to the idea of keeping the greenback strong even as the currency continues to lose value against its major and minor foreign rivals.

This is theater, but it’s still important in the scheme of things, says Dan Katzive, currency strategist at Credit Suisse in New York.

Although global markets fully expect the dollar to stay weak because of rock-bottom U.S. short-term interest rates and soaring federal borrowing (among other reasons), Katzive notes that it’s in everyone’s interest for any further decline in the buck to remain orderly -- which pretty much describes the drop since 2001.

The last thing the world needs is a sudden dollar collapse that could trigger market pandemonium.

The DXY index of the dollar’s value against six major rivals, including the euro and the yen, is down 37% since mid-2001, including this year’s slide of 7.6%.

With traders already inclined to keep selling the U.S. currency, imagine the market's reaction if Geithner were to say, "You know, we’ve thought about it, and we’d really like to see the dollar fall a lot more."

Even if the administration believes that -- given that a weakening buck is a boon to U.S. exporters -- no one in a position of power is going to say so, for fear of waving a red flag at markets.

Instead, by reiterating the stock phrase about dollar strength, "They’re assuring the markets that the U.S. isn’t going to talk the dollar down," Katzive says.

Besides, the administration has to be figuring there’s no reason to mess with success.

Consider: One long-term concern about a falling dollar is that it could undercut U.S. financial markets by scaring away foreign investors, whose dollar-denominated assets lose value as the greenback falls.

But the Treasury bond market isn’t suffering from a lack of investor demand even as the administration borrows record sums. And the U.S. stock market, too, remains robust, as investors see dollar weakness as good news for American multinational firms. The Dow Jones industrials are at a new one-year high today.

"It’s the best of everything right now," says Win Thin, a currency strategist at Brown Bros. Harriman in New York.

-- Tom Petruno

Photo: Treasury Secretary Timothy Geithner. Credit: Chris Ratcliffe / Bloomberg News

California debt binge shakes up muni bond market

The municipal bond market’s message to California: Enough with the borrowing already!

Over the last seven weeks the state has sold more than $21 billion of short- and long-term debt for budget-related reasons and to finance voter-approved infrastructure projects.

That flood -- in a period when muni bond yields nationwide already were rebounding after diving in summer -- has helped to boost yields more than they might otherwise have risen, some analysts assert.

"Yields are higher because California has so much paper in the market," said Matt Fabian, who tracks muni bond trends at Municipal Market Advisors in Westport, Conn.

The state has been its own worst enemy: Its borrowing costs have risen with each bond deal, which means taxpayers will bear a bigger hit to service the debt over time.

Rising market yields also have the effect of devaluing older fixed-rate muni bonds. If you own a California muni-bond mutual fund, chances are its share price has been sliding since the end of September as the  market has suffered indigestion from the supply of new bonds.

In California’s latest offering -- a sale Tuesday of nearly $1.9 billion of bonds maturing in June 2013 -- the state had to pony up for a 4% annualized tax-free yield to lure investors to the deal.

Less than two weeks ago the state paid a yield of 2.48% on a bond with a similar maturity.

Investors’ ability to squeeze 4% out of the state in this week’s deal "is an expression of saturation of the market" by California, said George Strickland, a muni bond fund manager at Thornburg Investment Management in Santa Fe, N.M.

Demand for the bonds sold Tuesday also may have suffered because the deal stemmed from one of the gimmicks concocted by the Legislature and Gov. Arnold Schwarzenegger in July to close the state’s huge budget deficit: The proceeds will repay local governments for the $2 billion in property tax revenue that the state is borrowing from them to plug the budget gap.

The bonds become part of the state’s overall debt burden, but they’re a step below so-called general obligation issues, which have an iron-clad repayment guarantee in the state Constitution.

Treasurer Bill Lockyer obviously knows that he has dumped a lot of debt on the market this autumn. He didn’t have much choice, given the budget fixes ordered by the Legislature, and given the backlog of infrastructure bonds California has to sell.

The state’s borrowing plans had been put on hold for much of this year because of the deepening budget crisis. "We had a lot of work to do to get our financing program back on track" this fall, said Tom Dresslar, Lockyer’s spokesman.

Of course, for investors with money to put to work, rising muni yields are welcome.

Ken Naehu, who manages bond investments at Bel Air Investment Advisors in L.A., believes the state’s budget woes are far from over, which Schwarzenegger acknowledged Tuesday. Still, a 4% tax-free yield on a bond maturing in less than four years was too good an opportunity to pass up, he said.

"We gave them a large order," Naehu said.

-- Tom Petruno

California forced to boost yield on bond sale to lure buyers

California has stumbled badly in its latest foray into the municipal bond market -- a sign that investors are overloaded with the state’s debt.

Borrowing $1.9 billion Tuesday via bonds that mature in June 2013, the state was forced to pay a 4% annualized tax-free yield to lure investors to the deal.

Just last Friday the brokerages underwriting the deal, led by Goldman Sachs, had estimated that the bonds could be sold at a yield of 3%.

Individual investors put in orders for $621 million of the securities, or about 33% of the total. But that wasn’t enough to give the state much leverage with the institutional investors whose demands determined the final yield on the debt.

The bonds were issued by the California Statewide Communities Development Authority, but it’s the state itself that’s on the hook. The proceeds will repay cities and counties for the $2 billion in property tax revenue that the state is borrowing from them -- some would say, stealing from them -- under terms of the budget deal the Legislature and Gov. Arnold Schwarzenegger reached in July.

California has borrowed heavily in recent months for budget-related reasons and to fund long-term infrastructure projects, and Treasurer Bill Lockyer has been selling into a market that has demanded ever-higher yields on Golden State debt.

That’s good for investors, but taxpayers will pay the price.

-- Tom Petruno

The Fed's 'road map' to higher interest rates

The Federal Reserve made clear Wednesday that it isn’t planning to raise short-term interest rates soon.

But the central bank also got more specific about the conditions that would spur it to lift its key rate from the current zero-to-0.25% range.

Here’s how the critical paragraph in the Fed’s post-meeting statement reads:

"The Committee will maintain the target range for the federal funds rate at 0 to 0.25% and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

The bolded type is what was added to that paragraph since the Fed’s last meeting on Sept. 23.

"In citing these three conditions, the Federal Reserve has provided a road map by which market participants can gauge with greater precision the evolution of monetary policy, in particular the exit strategy for the Fed’s current stance," Tony Crescenzi, a bond market strategist at Pimco in Newport Beach, wrote in a note to clients.

"This will make the implementation of the Fed’s exit strategy more a process than event," Crescenzi said. "It will also give the Fed an ‘out’ because incoming data related to the three conditions mentioned will take on greater weight than the Fed’s own words, allowing the Fed to simply rubberstamp the conclusions drawn by market participants regarding the incoming data."

The first condition mentioned -- "resource utilization" -- could apply to both labor and factory capacity, both of which are severely underutilized at the moment. No debate there. Even if the economy keeps expanding, the Fed is saying that it wants to see labor and industrial slack taken up before it will think about tightening credit.

To measure whether inflation trends are "subdued," the Fed presumably would rely on the government’s major inflation gauges, including the consumer price index and the so-called personal consumption expenditures price index. The year-over-year gains in the "core" indexes of those gauges were 1.5% and 1.3%, respectively, in September, which in both cases would qualify as "subdued."

To measure whether inflation expectations are "stable," the Fed could look at future price increases implied by interest rates on Treasury inflation-protected bonds, and at trends in gold prices and the dollar.

Crescenzi noted that the Fed’s statement specifically referred to longer-term inflation expectations as being "stable" at the moment.

But are they?

"It is intriguing that the Fed would label inflation expectations ‘stable’ when the amount of inflation expectations embedded in 10-year inflation-protected Treasuries reached its highest point of the year -- 2.14%, indicating that 10-year inflation-protected Treasuries are priced for the consumer price index to increase at a 2.14% [annualized] rate over the next 10 years," Crescenzi said.

Gold, hitting record highs this week, also could be signaling rising inflation expectations. But gold’s new bull run also could be pointing to something more visceral -- increased distrust of all paper currencies -- rather than heightened concern about inflation.

-- Tom Petruno

Post-Fed scorecard: Gold at new high, other markets slide

Gold’s latest rally powered ahead Wednesday as the Federal Reserve maintained a dovish attitude toward interest rates.

Meanwhile, the dollar, the stock market and longer-term Treasury bonds all sold off after the Fed issued its post-meeting statement, which repeated that policymakers expected to keep short-term rates low "for an extended period."

Near-term gold futures gained $2.40 to $1,086.70 an ounce, a new record closing high that lifted the year-to-date price gain to about 23%. The metal traded as high as $1,098.50 for the day, after surging nearly $31 on Tuesday on word of the Indian central bank's big purchase.

Not surprisingly, the likelihood of the U.S. maintaining near-zero short-term interest rates was a negative for the dollar, which helped bolster the case for gold. The euro jumped to $1.487 from $1.472 on Tuesday.

The stock market, which rallied early in the day on some relatively upbeat economic data, surrendered most of its gains in the final 30 minutes of the session -- a decline some analysts blamed on the U.S. House’s vote to speed up new limits on credit card interest rates. That slammed bank stocks. The Dow industrials closed up 30.23 points, or 0.3%, to 9,802.14, after being up as much as 156 points.

Some investors also dumped longer-term Treasury bonds post-Fed. The 30-year T-bond yield jumped to 4.40%, up from 4.33% on Tuesday and the highest since Aug. 14.

On the face of it, the markets might seem to be worried about the Fed falling behind the curve in keeping inflation subdued -- except, where do you find inflation these days, other than in asset prices? (OK, oil is a problem again lately, that is true.)

Nicholas Colas, investment strategist at BNY ConvergEx Group in New York, thinks the stock market’s disappointing action is just another sign that "it’s definitely in need of a breather here." Stocks have been struggling since peaking in mid-October as more investors have turned cautious about the near-term economic outlook.

The Standard & Poor’s 500 index, which edged up 0.1% on Wednesday to 1,046.50, is down 4.7% from its one-year closing high of 1,097.91 on Oct. 19.

"The biggest single question is, how are consumers thinking about their prospects going into Christmas?" Colas said. People may think better about their prospects if they have more faith that job cuts are ebbing -- which is why the government’s report Friday on October employment trends will be key, as usual.

As for the sell-off in the bond market, traders noted that the Treasury on Wednesday gave more details about its plan to lengthen the average maturity of the government’s debt load, which of course means issuing more longer-term debt and fewer shorter-term securities. That may have triggered some knee-jerk selling of longer-term bonds.

As I noted in this post, the trend no one would want to see take hold this month (or any month) would be rising bond yields accompanied by falling stock prices. Just something to watch.

-- Tom Petruno

Photo credit: Genaro Molina / Los Angeles Times